Summary: The AQR treatment on accounting impairment demonstrates how important prudential valuation can be in the future if the ECB continues to use it. In this case, banks will have to consider the differences between accounting and prudential valuation to ensure an adequate and integrated capital and balance sheet management, as long as accounting impairment is based on the incurred loss model. A reliance on accounting valuation to manage the balance sheet may not suffice. 


The three elements of the Comprehensive Assessment are the Supervisory Risk Assessment, the Asset Quality Review (AQR),  and the Stresstest. Together, these elements provide an in-depth understanding of material balance sheet risks. As economic risks are linked to balance sheet calculation, it is crucial to differentiate between the application of adequately interpreted accounting rules on one side, and the prudential adjustments required by the Comprehensive Assessment on the other side. The latter shall assure a proper and (more) harmonised calculation of the CET1 (Common Equity Tier1). Both, the identification of prudential balance sheet adjustments and the recalculation of CET1 is be part of the AQR. The AQR itself comprises three key phases:

  • portfolio selection: result- identification of exposures with the highest risk and portfolios which should be included in the execution phase; status: completed
  • execution: result:-identification of prudential balance sheet adjustments ; status: on-going
  • collation: result- AQR adjustment calculation to CET1; status: scheduled for July 2014

With respect to the close relation between accounting and prudential valuation it is important to note that the “AQR should not be seen as an attempt to introduce greater prescription into the accounting rules outside of the existing mechanisms.” Among others, the following questions arise:

Impact of the prudential AQR valuation adjustments on bank accounting: The ECB states that “Banks would not be expected to incorporate into policies, processes or reporting findings from the AQR that relate to a bank failing to be the right side of the ECB threshold if they are compliant with the relevant accounting principles. The bank would not be required to restate accounts or apply the AQR assumptions on an on-going basis, i.e. the AQR-adjusted CET1% is not a de- facto alternative accounting standard.”

Treatment of prudential adjustments on accounting valuation in the course of the Comprehensive Assessment: “The AQR will generate a series of parameters that will act as inputs to the stress test process. The key inputs to the stress test will be: any adjustments to data segmentation highlighted by DIV, an AQR-adjusted Common Equity Tier 1% (CET1%) parameter (to allow the impact of the AQR to be applied to stress test projections of the CET1%) and probability of Impairment (PI) and Loss Given Impairment (LGI) parameters for use in the stress test. The way these parameters will be used in the stress test is pending the final methodology for the stress test, which is currently underway. As mentioned, the AQR-adjusted CET1% will be used to compute the final stress test outcomes.” One follow-up action of the ECB can be, however, to ask banks to capitalise for a shortfall relative to the ECB threshold in incremental Pillar 2 capital requirements.

Consequences if the ECB concludes that the accounting rules used by the bank are not in line with best practice interpretations: Following completion of the Comprehensive Assessment, “NCAs will produce a letter to significant banks outlining any areas where the bank is found to be outside of accounting principles and the required remediation actions the bank would be expected to take (including adjustments to the carrying values of assets). These issues would be expected to lead to adjustments to available capital and hence be reflected in Pillar 1 capital requirements at the next relevant reporting date. For the purposes of clarity,  areas where the bank falls short of the “ECB threshold” but is in line with accounting standards would not be included in the letter to the bank.”

The  case of prudential impairment calculationIAS 39, Para 59 (EU) states: “A financial asset […] is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset […] that can be reliably estimated. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. Losses expected as a result of future events, no matter how likely, are not recognised. […]” The ECB defines the following approach in its AQR-Phase2-Manual: “Initially, the NCA bank team will compare the impairment triggers of the significant bank as of December 31st with the minimum triggers provided in Table 38 of the manual and the loss events stipulated IAS 39. Where the significant bank has defined additional or more conservative triggers, these should also be taken into consideration in addition to the minimum triggers. This implies that the evidence of impairment definition is at least as conservative as the significant bank’s current classification.The NCA bank team should assess each exposure in the sample for objective evidence of impairment on December 31st 2013. This requires a two-step approach:

  • First, assessment for each exposure whether a loss event has happened based on the triggers provided. Not all of the triggers apply to each debtor (e.g. CDS is not relevant for retail mortgages or large SME).
  • Second, for each exposure with a loss event, the assessment whether the loss event has an “impact on the estimated future cash flows” of the exposure. If this is the case, the exposure will be considered as having evidence of impairment.“

In contrast to the above mentioned criteria, current or past cash flows do not necessarily need to be impacted for an exposure to be considered impaired according to IAS 39. Additionally “NCA bank teams will classify exposures as having evidence of impairment irrespective of whether the impacted future cash flows indicate that an impairment loss should be registered (i.e. impaired loans where impairment loss is assessed as 0 due to collateral should be viewed as being impaired because cash flows will be impacted by the foreclosure of collateral).”

From March 31th on, banks will have to regularly report detailed components of the Liquidity Coverage Ratio and the Leverage Ratio. The final European rules shall be defined by the EU-Commission until June 30th. To address remaining issues a public hearing took place on March 10th. As expected, the EU Commission points to deviations from European CRR rules and tends to follow the international Basel3 rules, in line with the latest EBA recommendations.

Main take-aways are (see also stakeholder-paper_en):

For the Leverage Ratio, the EU-Commission seems to follow the EBA report issued on 4 March 2014. EBA emphasized that the analysis underlying their report has not indicated any EU specificities which would lead to recommend a divergence from the Basel rules text.

Three hours of the 4 hour meeting were reserved for the Liquidity Coverage Ratio. The EBA addressed main issues in its report dating from December 2013. Remaining questions, among others, concern the components of the liquidity buffer:

  • Shall Covered Bonds be Level 1 or/and Level 2 assets: The European Covered Bonds Council sketched that Covered Bonds have been more stable throughout the financial crises than other asset classes. It is also important to note that a classification to either L1 or L2 depending on the rating adversely impacts the comparability as European jurisdictions have different Covered Bond Regulations.
  • Shall the currently known standby Credit Facility of Central Banks be part of the liquidity buffer: There is strong evidence that contrary to the CRR regulations, the final LCR rules will not include these kind of facilities. Instead, priced facilities shall be used by Central Banks to better manage the liquidity flows, as suggested by EBA and BCBS.
  • Shall securitisations be part of the liquidity buffer: Up to now only RMBS are included. A controversial discussion concerning Automotive-ABS led to the following statements: First, the EU Commission indicated that this will be under review in the future. It shall be monitored together with new regulations of the European securitisation markets. Second, the EBA states that the pool of liquid assets has to be directly managed by a bank. In this sense, RMBS is an exemption, but it is in line with the Basel rules.

Finally, several indications given throughout the Public Hearing point to a limitation of Level 2/ High Quality Liquid Assets in line with the Basel rules (max 40% L2).

Liquidity Risk was one of the main drivers of the financial crisis. To increase stress resistance in case of a systemic liquidity shortfall that hits asset and funding markets, the regulator asks banks to improve transparency and liquidity risk management. One element of the new Liquidity Framework is the Liquidity Coverage Ratio (LCR): Banks shall hold sufficient High Quality Liquid Assets (HQLA) to fund net cash outflows under stressed markets for a period of 30 days. The LCR will be binding from January 1st 2015 on. Final provisions are expected until June 30th 2014.

There is evidence that the LCR has little impact on bank strategy. Heiko Hesse and Stefan W Schmitz note:

  • An analysis of the European Banking Authority (EBA) shows that between Q2 2011 and Q4 2012, banks adjusted their balance sheets mainly by increasing their holdings of HQLA (especially drawable central bank reserves, sovereign bonds, and covered bonds).
  • Reductions of net cash outflows played a lesser role. 
  • In general, banks with an estimated LCR shortfall have a number of ways in their funding plans to become compliant (e.g. lengthen the maturity of their (unsecured) wholesale funding beyond 30 days, promote deposits, reduce costly uncommitted credit lines or increase their proportion of liquid assets in their balance sheets.
  • The overall finding that the LCR does not reduce lending to the real economy, SMEs, or trade finance is corroborated by a recent survey of Zeb (2013) which finds that banks in their sample (23 Austrian and German banks) mainly plan to adjust by reducing unsecured/secured outflows, increasing HQLA and committed lines, but not by cutting loans to the real economy.

Besides bank strategy, the EBA expects that the shortfall of HQLA has little impact on prices and demand on the financial markets: Some jurisdictions show severe shortfalls. Overall, the extra demand for HQLA is at about EUR 70 to 264 billion. This amounts to only 0.6 to 2.4% of the total market size.

Overall the LCR seems to have little impact on bank strategy and bank funding of the real economy. Still, the rules with regard to LCR are not final. Main parts of the HQLA are still under discussion, such as the inclusion of central bank facilities, which is allowed by the CRR, but criticised by EBA and  the Basel Committee on Banking Supervision. The outcome of this discussion may result in changes to said findings. However, we expect main drivers for bank strategy resulting from the controversial field of capital requirements and cost income measures and less from the LCR.

2013 was a year full of new regulatory impulses. 2014 is the year of major changes in Bank Regulation and Supervision.
The ECB Supervisory Board convened for the first time this year in January.  Following this meeting, Ms. Nouy, Chairperson, stated: “We have to accept that some banks have no future,” and: “We have to let some disappear in an orderly fashion, and not necessarily try to merge them with other institutions.” This statement is remarkable as main preconditions to restructure the European financial system are still work in progress. Current issues are:
         Which banks „have no future“?
         Who decides if a bank shall be liquidated?
         Who pays for it?
Banks with no future: Since February this year, Joint Supervisory Teams and auditors collaborate to conduct an on site Asset Quality Review.  Its outcome is meant to identify European banks that might be restructured or liquidated if they do not meet the thresholds set by the joint ECB and EBA stress tests. Final results of the Comprehensive Assessment are expected in October 2014 at the latest. We expect further stress tests to follow.
The decision to liquidate a bank and the source of the funds required to do so: These are major issues currently discussed by the European lawmakers, which are scheduled to be resolved until April 2014 before the EU parliament adjourns for May elections.
Last week’s negotiations between EU precidency, commission, parliament and council established the following concerning the resolution decision:
  • The ECB will be charged with the task of determining if a bank is failing or likely to fail.
  • The committee which will be charged with the decision upon the resolution of a bank is still in discussion. German Finance Minister Wolfgang Schäuble suggests decision making shall take place through the plenary session of the Supervisory Board. Other interested parties are asking for more independence from national influence and favor a decision by the Executive Board. The final decision lies either with the commission or the council.

Concerning the funding of the resolution costs it appears that Finance Ministers across the EU recognize a common need to demonstrate the European financial system’s robustness in a crisis. Clearly, the time period allowed for the SRM fund’s pooling will be key to signaling this strength. Accelerated funds pooling and/or an additional backstop such as the ESM are possible approaches. Details are currently debated as well.

In view of these developments, movement toward restoring market credibility and restructuring the European financial system can be seen. The question remains: Who pays the bill? The ongoing negotiation on the SRM funds are connected to points already set in 2013: SRM funds shall only be used after Bail-In has taken place. The Bail-In rules will enter into force on January 2016, together with the pooling of SRM funds.
In the meanwhile and with respect to the 2014 Comprehensive Assessment results, EBA and ECB asked the European Finance Minister to help banks “disappear in an orderly fashion“ by making sure that there are national resources available to carry potential recapitalisation or resolution costs. It is essential that each country contributes its part. This understanding is also mirrored by the  ESM-regulation. It states that ESM funds shall only be used for direct bank recapitalisation if the respective country cannot provide the required stake.

Dear All,

Thank you for your interest in bankenanalyse throughout 2013. This year was marked by fundamental changes in bank regulation. In 2014, we look forward to more transparency on the impact on the regulated and shadow banking system. Future research and market adjustments will show if the goal to increase financial stability, as set by the G20 Finance Ministers in 2008, can be reached. The European Banking Supervisory Board will play a crucial role in this.

The next Bankenanalyse posts will appear starting February 2014. We wish you the best for a festive season and a prosperous new year.

Your Bankenanalyse


As this year comes to a close, we want to use the opportunity for an open letter to Mrs. Danièle Nouy, appointed chairperson of the Supervisory Board at the ECB, concerning the Single Rule Book with respect to goals and challenges of 2014.


Dear Mrs. Nouy,

the responsibility you assumed is probably the most challenging in banking business today. To qualify what is meant by “challenging” , we refer to your role as Chairperson of the Supervisory Board, which does not only require diplomacy, handling various interests which European Economies and Finance Ministers have, but also requires a strong leadership to assure consistent supervisory work which focuses on a harmonised European playing field. As defined by the G20, bank comparability and transparency is crucial to restore confidence in the regulated banking system. This is also valid for the shadow banking activities. Much work has been done so far: the fundament of the European Banking Union, the Single Rule Book, will come into force starting January 1st. To achieve the goals set, political and operational challenges must be addressed.

The potential renationalisation of bank rules presents a huge challenge on the political side. A prominent example of this is the reclassification of Deferred Tax Assets. A basic guideline of the Single Rule Book stipulates that regulatory capital has to be fully paid in. Spanish banks, by contrast, use a reclassification to improve capital ratios. This example should not be construed as fingerpointing. It is simply an example for different economic situations requesting national solutions which may be in contrast to the Single Rule Book.

On the operational level, it will be crucial to understand and react to bank’s market behavior. Let us take the connection between state finance and banks as an example. The Italian sovereign exposures of domestic banks amount to about 9 percent of the assets, mostly in trading and available-for-sales accounts. As the Monetary and Capital Markets Department of the IMF states, „this exposure is relatively large compared to other advanced economies, and Italian sovereign spreads have been experienced periods of above- average volatility. Mark-to-market valuation losses could affect bank solvency, while lower market prices for sovereign bonds would reduce their collateral value for secured funding, including from the ECB. Besides direct effects, the experience of the European debt crisis suggests that acute sovereign distress can have a broader impact on the economy, further aggravating pressures on the financial sector.“ To reduce the exposure towards mark-to-market losses by rising rates, it is plausible to see more and more banks shifting sovereign bond from their available-for-sale portfolios to held-to-maturity, which will mitigate the impact that movements in the bond markets have on their tangible book values and common equity. These adjustments have an impact on key figures. A proper understanding of how figures are interconnected is essential. To remain with the Italian bank example, a high sovereign exposure goes together with a relatively high rate of ECB eligible collateral. This has a positive impact on liquidity ratios. The asset encumbrance ratio for Italian Banks shows two main patterns: first, it significantly increased from 2011 to 2013. Second, government bonds remain the main source of unencumbered assets. A decrease in mark-to-market value may have a significant impact on the asset encumbrance ratio and the possibility to refund in stressed sovereign markets.



12-2013_ECB eligible collateral

Supervisory Reporting, which is addressed in the Single Rule Book, does reference these connections. It remains a challenge to draw the right conclusions, as each market and jurisdiction, but also each bank’s business model has its own logic. This already becomes evident in the course of the Comprehensive Assessment.

Currently, the ECB collects information in preparation for the Comprehensive Assessment. Key questions, which are basic for restoring confidence in the European bank balance sheets, are still open to be answered. What level of provisions will the ECB require against nonperforming loans? How will it stress test banks’ exposure to sovereign debt? How will it stress test the safety and soundness of bank funding structures, including continued reliance on ECB facilities and the recent sharp rise in ultra short-term market funding? In the words of Simon Nixon (WallStreet Journal): „What is becoming clear is that the Comprehensive Assessment may not be as comprehensive as some had hoped. The ECB will be bound by existing national rules relating to provisions and quality of capital. Indeed, some officials fear the ECB is being burdened with excessively high ambitions: It is unrealistic to expect the Comprehensive Assessment to lead to a miraculous transformation in the euro zone’s financial landscape. Yet without a transformation in the financial landscape, the ECB is likely to come under further pressure to adopt radical measures to ease borrowing costs in the periphery.“

There are many questions to be answered on the course to developing a European financial system.

Bankenanalyse sees two key ingredients which are required to handle these challenges. These are structures allowing swift and decisive decision making as well as staff which is taking responsibility to address operational hurdles and level inconsistencies to reach the defined goals.

With best wishes for a peaceful festive season and a successful 2014,


By definition, focused analysis results always depend on the factors taken into account. In this article, we will focus on main drivers explaining funding at a bank-specific level. Current trends suggest that Banks prepare for a switch from collateralised funding, such as Covered Bonds, to more unsecured funding.

To start, let us explore the following question: What is the ratio behind changing funding patterns?

From 2008 on most investors were looking for safe bank funding, if at all. Bank funding was mainly buy-side driven. Let us consider the following figures: European Covered Bond issues reached their peak in 2011, with a total of 370 billion US-Dollars. In addition to the market expectations, we understand regulatory uncertainty as a further driver which pushed secured funding. Specifically, Covered Bonds were expected to play a crucial role in fulfilling the requirements defined by the Liquidity Coverage Ratio. With respect to the final rules, Covered Bonds are still important. Their dominant impact, however, is balanced by alternative factors allowing to calculate an adequate Liquidity Coverage Ratio.

Between 2011 and 2013 the factors defining bank funding patterns changed: In 2013 the issuance of Covered Bonds fell back to a 2002 level. This break in the above-mentioned trend towards the 2011 peak occured even though the investors have been showing a stable demand for secured funding. What are the new drivers shifting the funding patterns to (relatively) more unsecured funding? Karlo Fuchs, Senior Director of Covered Bonds at S&P points out the following: First, banks focus more on deleveraging their balance sheets leading to less covered bonds. Second, banks are heavily working on meeting new targets set by the regulators, such as the Leverage Ratio and the Asset Encumbrance Ratio. In addition, regulatory grandfathering rules have the potential to wipe out parts of existing Additional Tier 1, in case a step up is combined with a call date and if the instrument does not fully comply with the criteria of Article 52 CRR.

We understand that these factors further push the issuance of unsecured debt in 2014/2015. The question if those instruments will be structured as Contingent Convertible Bonds will depend on the bank-specific funding mix and the tax treatment of those bonds, among other factors. Gerald Podobnik, Head of Capital Solutions at Deutsche Bank, weighs in on this topic in an FT article, stating that an “avalanche” of Additional Tier 1 contingent convertible bonds from European banks is expected in 2014 amid efforts to build capital buffers and boost leverage ratios. According to Dealogic data EU banks have issued a record 9.6 billion US-Dollars in CoCos to date in 2013; Podobnik expects up to 30 billion US-Dollars for 2014. The decisive factor for the final design of unsecured funding instruments will depend on bank-specific key indicators such as capital, leverage and encumbrance ratio.